Wednesday, May 6, 2009

Next time I see an article with the words “dollar,” “collapse” and “China” in the same sentence, I’ll dump it straight to the recycling bin… I suggest you do the same.

The latest such gem comes in the form of an op-ed piece by “independent economist” Andy Xie in the Financial Times.

Xie’s thesis is that the Fed’s recent money-printing binge risks undermining global confidence in the US dollar as a store of value and (as a result) as a reserve currency. In turn, if loss of confidence prompts China to accelerate the process of deepening its financial and exchange rate markets, “the dollar will collapse”.

Big words, somber conclusions, yet unfortunately for Xie, his arguments are too thin to support them.

Let’s first get the money-printing argument out of the way. Coming from an “economist”, it reveals a puzzling lack of understanding of the reasons that made the expansion in base money since last September a necessity—namely the unanticipated surge in the demand for the safest and most liquid form of dollar assets—like, money(!)—by the private sector in the US and abroad, as the financial crisis escalated.

I do admit that the Fed’s decision to buy Treasuries does not easily fall under the “necessity” argument. It’s also one that I myself have protested many a time on both theoretical and empirical grounds. But, it’s also one that China should be happy about, as it serves to support the very securities that it holds in its reserves. Indeed, one of the (many) reasons I think the Fed’s Treasury purchases is a waste is the “leakages” that would arise IF the likes of China take it as an opportunity to sell their own holdings.

I don’t want to downplay “exit”-related risks—risks that the Fed is very much aware of and alert to. But the focus on base money expansion as a harbinger of the dollar’s future collapse is a very narrow one, because it is predicated on the assumption that adjustment in the real economy will not be forthcoming.

But this is a wild assumption. The future shape and structure of the US (and the global) economy is admittedly tough to predict but, in the meantime, adjustment has already been forthcoming. The US current account deficit has shrunk by 3% of GDP since its peak at end-2005; and the savings rate jumped back up to 4.2%, its level in the late 1990s, as spending declined. And while the explosion of the fiscal deficit looks scary, a closer look at the numbers suggests the impact on the national balance sheet (public+private) may actually be smaller than you think.

Specifically, CBO projections show that a good chunk of the surge in the deficit (some 5% of GDP) is driven by the TARP and Fannie/Freddie-related subsidies—which basically amounts to the public sector taking over private-sector liabilities. Unless the private sector begins to re-leverage soon, the net impact on the national balance sheet will be small.

In addition, on the revenue side, a big part of the projected decline is in the taxes on realized capital gains. In better years, these gains were partly directed to finance discretionary household spending—spending that won’t be repeated any time soon, unless we get a J-shaped upturn in the stock and housing markets. Translation: Higher household saving offsetting the fiscal dissaving.

The bottom line here is that adjustment is already happening--it’s just not the kind of adjustment that China likes to see, given the over-reliance of its recent growth model on US consumers.

Which brings me to a more important point: Xie’s focus on the potential flaws in the US policy response to the crisis diverts the attention from the blunders of China’s own policy framework, notably the glacial speed of its capital markets reforms.

If the ethnic Chinese have a problem, it’s in their own back yard: Their problem is that both their savings rate, and the assets to which those savings are allocated to, are determined, by and large, by their government.

This makes Xie’s suggestion that America should conduct asset sales to fix its balance sheet all the more laughable. I mean, dude, hello? US assets have been available for sale to foreigners for decades, be it an equity stake in Microsoft or a villa in the Hamptons. Only that interested buyers must be able to get their money out of their own country first. The ethnic Chinese can’t (with some exceptions), thanks to their own government’s policies. Meanwhile, their government invests in US Treasuries.

This brings me on to my next point… What will happen when China does move to liberalize its capital markets, floats its exchange rate and opens up its capital account (steps I would be delighted to witness in my lifetime)?

It’s far from clear that the dollar would collapse. Notwithstanding the stunning accumulation of foreign exchange reserves by the Chinese government, China on aggregate remains substantially “home-biased” compared to an advanced-economy average. Increased sophistication of its investors and its capital markets could therefore well imply a higher share of foreign asset holdings. The US dollar would be a lead beneficiary of this home-bias-reduction process, provided of course that the US retains a dominant share of world capital markets in the foreseeable future.

Finally, could the dollar collapse, say due to a spectacular screw-up by the Fed/Treasury/Congress combo? Possibly, but it, in my view, it will have to be a truly spectacular screw-up, given the absence of enough viable alternatives that can serve as havens of liquidity and safety. Moreover, one should consider the sharp adjustments that would be forced upon the rest of the world (e.g. the rapid correction of the Asian trade surpluses), which, in turn, would put pressures on the currencies of those countries to depreciate.

Not everything is rosy in the US dollar realm.. And flaws in the US policy response have been aplenty, especially as politics has inevitably gotten in the way. But rather than coming up with ominous warnings against potential US policy mess-ups, China should focus on acknowledging its own role into the genesis of this crisis and then do something about it. The world would welcome that, even as it still keeps its good share of US dollars!

I am not an economist, so maybe the answer to this question is quite obvious. You speak about the necessity for the Fed to lower interest rates and participate in quantitive easing, as there was an exuberant demand for US Dollars. I do agree with that statement, however, you also say that the Chinese Government should be happy about it, not because these measures hinder the deepening of the global financial crisis, but because it supports the securities in Chinese reserves. I thought that as these measures decrease the value of the dollar, they also diminish the value of those securities. Please, could you tell me at which point my argument goes off rail? Thanks a lot.

johannes, the depreciation of the dollar due to the Fed's expansion of money is by no means a "given"... see what happened back in october '08.. the dollar strengthened sharply, even while the Fed was expanding its balance sheet fast.. that was because there was a huge and unanticipated demand for dollars (for funding or "safe" haven purposes) and the Fed monetary expansion was merely a response to that demand.

Going forward, key for the dollar's future will be the speed at which the Fed will reverse the monetary expansion as economic conditions improve and inflation emerges in the horizon. The Fed claims it is building the tools to manage that reversal smoothly--I very much believe that, but I would also like that they come out with a clear ranking of their policy objectives, esp with regard to their inflation tolerance while growth remains subpar. My point there is that, if the Fed came clean about its inflation objective, this would help reassure you, the Chinese and the many others who see inflation down the line that they need not fear.. but you tell me if i'm right about that!

Chevelle, I appreciate this post and agree with mostly all of your points. One question regarding "provided of course that the US retains a dominant share of world capital markets in the foreseeable future." - prior to the bust the US capital markets were losing great market share to Hong Kong and City of London. Wouldn't the removal of home bias in China result in this capital activity being conducted in Hong Kong? Or do i have a misinterpretation of what you refer to as a "share of world capital markets"?

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actually, the concept of home bias is not related to the location of financial transations (US, UK, Hong Kong etc). Rather, it is related to the portion of total assets that an investor will choose to allocate at home compared to foreign markets.

Let's say we lived in a world of equities alone. If your country accounts for 10% of world market capitalization, but you actually have 85% of your assets in domestic equities and only 15% in foreign ones, you are heavily home biased. You are not home-biased if you have 10% of your assets in domestic stocks and 90% in foreign ones.

Along these lines, if Chinese investors were allowed to invest abroad freely, and at the same time reduced their home bias to the average levels of advanced economies, they would likely put a lot of their money in the US, since US equity markets account for a very large share of global market capitalization.